PLANNING AND FUNDING ASSET REPLACEMENT: ONE AGENCY’S EXPERIENCE V. Kenneth Harlow, Director of Management Services Brown and Caldwell 16735 Von Karman Avenue, Suite 200 Irvine, CA 92606 and Andrew V. Czorny, Associate General Manager and Chief Financial Officer Orange County Water District 10500 Ellis Avenue Fountain Valley, CA 92708

INTRODUCTION This paper describes the approach taken by the Orange County Water District, headquartered in Fountain Valley, California, to funding its future infrastructure replacements. The paper presents: ¾The funding methodology chosen and the tools used. ¾Issues that arose during implementation. ¾Guidelines prepared to help staff determine whether expenditures qualify for funding from the Replacement Fund. ¾Ongoing maintenance of replacement funding policy. This paper will be of interest to any agency concerned with sound asset management and maintaining the quality and viability of its infrastructure over the long term. The approach described also satisfies substantial portions of the requirements of Governmental Accounting Standards Board Statement 34 (GASB 34), especially that statement’s modified approach, and the “Capacity Management, Operations, and Maintenance” (cMOM) regulations proposed as part of NPDES permitting requirements and applying primarily to wastewater agencies. KEYWORDS Asset replacement, asset management, replacement planning, refurbishment, GASB 34, cMOM.

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ORANGE COUNTY WATER DISTRICT Orange County Water District (OCWD), a major California groundwater management agency, provides three-quarters of the drinking water for 2.2 million people. Its activities include research, water quality monitoring, basin recharge, and treatment and re-use of wastewater effluent provided by the neighboring Orange County Sanitation District (OCSD). Recharge is conducted primarily along the Santa Ana River, where river flows are captured and percolated in basins and in the riverbed itself. When river flows are insufficient, interruptible Colorado River water is purchased from the Metropolitan Water District of Southern California and similarly stored in the groundwater basin for future use. Groundwater is withdrawn through wells of OCWD’s member agencies, who pay a fixed charge per acre-foot to maintain the OCWD’s operations. Reclaimed wastewater is used in two ways: 1. Water from OCWD’s Green Acres treatment plant is distributed for park, median, and golf course irrigation and related uses. 2. Water from OCWD’s Water Factory 21 treatment plant is blended and injected as a salt water intrusion barrier, to protect the basin from coastal saline intrusion. OCWD and OCSD have now jointly entered into a new venture called the Groundwater Replenishment System (GWRS), a large-scale project to produce 250,000 acre-feet annually of new water, reclaimed from wastewater effluent, for basin recharge. GWRS water will be of exceptional quality, superior to both sources of water now used for recharge, and will be reliably available even in times of drought. Partly in view of this project, which will mean a considerable expansion of OCWD’s assets, the agency thought it important to take steps to ensure the long-term quality and viability of its infrastructure. To do this, it needed policies for funding the ongoing refurbishment and replacement of its system assets. REPLACEMENT PLANNING APPROACH OCWD decided to adopt an approach already used successfully by several other California agencies. This approach relies on an inventory of system assets and specialized software to estimate replacement and refurbishment needs, on a year-by-year basis, over a period of many years. The software, called the Replacement Planning Model (RPM), is modified to suit each agency’s reporting requirements. In this case, the RPM was further modified to calculate the Reproduction Cost New Less Depreciation (RCNLD) of system assets, in order to establish annexation fees for agencies wanting to annex to OCWD.

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Once the RPM has determined likely replacement needs in the future, the user models a Replacement Fund to serve those needs. The goal is to establish an appropriate initial balance and a fixed replenishment amount from operational revenues. Even though the expenditures from the Replacement Fund vary widely from year to year, the annual appropriation to the Fund remains constant and the Fund serves as an equalization device. The Fund balance never grows too large, nor is it exhausted. This approach has been called “just-in-time replacement funding” as it avoids certain problems with the so-called “full accrual” replacement planning approach, which tends to accumulate unnecessarily large reserves if fully implemented. OCWD’s approach was based on engineer’s estimates of useful lives and current replacement costs. Planned replacement years for specific assets were used where known; otherwise, replacement timing for each asset was calculated from the year placed in service and the estimated useful life. Considerable other information was also required to model the financial portion of the simulation and to take into account the specific needs of OCWD. An idea of the information required can be gained by inspection of the RPM’s “Control Panel,” shown in the following illustration:

Figure 1: RPM Control Panel

As the figure indicates, additional information may be entered on secondary screens (not shown here): ¾Default useful lives for major asset classes can be increased or decreased to examine the effects on future funding needs.

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¾Issuances of bonds can be simulated to meet peak replacement cost demands exceeding the capacity of the Replacement Fund. ¾Unrelated cash flows can be entered to supplement or draw from the Replacement Fund. ¾Future rate surcharges can be modeled if this appears necessary to meet replacement funding demands. The RPM generates a number of graphical reports, each backed by a tabular presentation. Here is the primary menu of reports used by OCWD:

Figure 2: RPM Report Menu

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The first two reports are the most important in establishing replacement funding policy. The Replacement Fund Expenditures graph shows the actual replacement needs over the period specified for analysis:

Figure 3: Forecasted Replacement Fund Expenditures

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The Replacement Fund Ending Balances graph shows the actual performance of the Replacement Fund. As can be seen, the funding policies chosen in this case keep the Fund intact and at positive balances over the entire planning period, without accumulating excessively large reserves in the interim, although the Fund approaches exhaustion in the final years of analysis:

Figure 4: Forecasted Replacement Fund Balances

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Like other graphical reports, the Replacement Fund Ending Balances graph is supported by a detailed table, linked from the Table button on the upper left corner of the graph (partial table shown here):

Figure 5: Replacement Fund Activity Summary (partial)

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Two of the many other reports include a replacement value summary, with or without depreciation —

Figure 6: Asset Replacement Value Summary

and a log of replacements as calculated by the RPM.

Figure 7: Fixed Asset Replacement Schedule (partial)

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Other graphical and tabular reports are available, but descriptions are beyond the scope of this paper. IMPLEMENTATION ISSUES As a result of the analysis by OCWD staff conducted with the help of the RPM, the Board of Directors approved a funding policy for future asset replacements. The policy included the dedication of a specific portion of OCWD financial reserves for asset replacements (the Replacement Fund), and a commitment to a fixed annual appropriation to the replacement reserve. Implementation raised a number of issues that may have to be addressed by other agencies maintaining a Replacement Fund and monitoring its actual performance. These issues primarily involved two questions: What is a Refurbishment? What is a Replacement? As each department and division prepared its budget proposals, it had to identify the fund associated with each planned expenditure. Issues that arose included questions such as: ¾“We need to replace meters and pump impellors as they are drawn from stock for routine maintenance. Should these be funded from the Replacement Fund?” ¾“We’re replacing a pickup, but want the new one to be four-wheel drive with an extended cab. It will cost 50 percent more. How do we handle this?” ¾“We’re replacing several desktop computers. The new computers will be far more powerful than the old ones, but the costs will be about the same. Which fund should we charge to?” ¾“Some of our analytical equipment is obsolete, even though it’s only three years old. It cannot detect contaminants at the levels required by new regulations. Does this qualify as a Replacement Fund expenditure?” ¾“One of our injection wells is failing. We want to replace it with a new one, but to leave the old well in place with limited capacity. Is this a replacement?” ¾“We want to extend the lives of some of our pipes by interior coating. Is this a qualifying cost?” To address these and similar questions, staff prepared guidelines to help determine whether or not an expenditure was for refurbishment or replacement and whether it qualified for funding from the Replacement Fund. An important note: OCWD’s accounting system made it very difficult to fund an expenditure from more than one source. If multiple-source funding had been possible, these guidelines might have been somewhat different.

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GUIDELINES FOR FUNDING REPLACEMENTS AND REFURBISHMENTS The following are the guidelines prepared by staff to help clarify how budget requests should be handled: Purpose of the Fund—The Replacement Fund is intended to pay for assets that replace existing assets (“replacements”) and for investments that materially extend the lives of existing assets (“refurbishments”). Replacement Criteria—A qualifying asset will replace the functionality of an existing asset, and the existing asset will be taken out of service or remain in a state of severely impaired functionality. ¾Example: A three-mile length of pipeline is deteriorated and incurring high O&M costs. The pipeline is replaced. ¾Example: A front-end loader has too many hours and it is considered most economical to buy a new one and scrap the old. ¾Example: A building is deteriorated to the point that a decision is made to raze it and erect a new building. Refurbishment Criteria—A qualifying investment will maintain an existing asset’s functionality, will have a value of greater that $3,000, and will extend the asset’s life by three years or more. ¾Example: The life of the deteriorated pipeline (see above) life is extended through slipseal or some other form of interior coating. ¾Example: Upon inspection, it appears that the font-end loader will be good for another three years with a major motor overhaul and new transmission. ¾Example: Management decides that the old building can be used for many more years if it has a new roof, HVAC overhaul, and replacement of the tenant improvements. Upgrades—Many times a replacement asset extends or improves the original asset’s functionality. We call this an upgrade. It is not the intent of the Replacement Fund to pay for upgrades, but upgrades may qualify for funding as replacements under certain circumstances. Upgrade Criteria—An upgrade will qualify for funding if: (1) The functionality of the new asset includes the functionality of the asset being replaced; (2) management agrees that the added functionality is required or desirable; and (3) the cost of the new asset does not exceed 130% of the original cost of the asset being replaced on an inflation-adjusted basis. ¾Example: A desktop computer is limited in its functionality (memory, disk space, etc.) and cannot satisfactorily run current software. It is donated to the School District and replaced with a more current model. The new computer costs less than the old one.

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¾Example: A laboratory measuring device is replaced because regulations now require more sensitive measurements of certain chemicals in the water. The original equipment cost $4,500; the new equipment costs $5,500. ¾Example: A two-wheel drive pickup truck is replaced with a four-wheel drive truck. Management agrees that four-wheel drive is required and the cost is $1,500 more than the old truck. Additions—An addition is the placing in service of an asset that does not replace the functionality of an existing asset being taken out of service or extend the life of an existing asset. The Replacement Fund does not pay for additions. ¾Example: The old pipeline has limited capacity. A new pipeline is built to parallel it. ¾Example: The old front-end loader is still usable (perhaps the overhaul was done) but management decides to buy a new one anyway, perhaps to meet increasing workload. ¾Example: Management retains and continues to use the old building and, in addition, erects a new one. ¾Example: A new desktop computer is purchased that does not correspond to another older computer being taken out of service. MAINTAINING REPLACEMENT FUNDING POLICY OCWD plans to update the RPM periodically so that its financial policies can be reviewed in light of a growing asset base and the actual performance of the Replacement Fund. The model’s asset database has already been updated to the year 2000—the original database was completed in 1999. This update consisted of: ¾Correcting any errors discovered in the original asset database. ¾Adding new assets to the database that had been placed in service during the preceding year. ¾Updating the “future plant” portion of the database to reflect the latest capital improvement plan (future plant is included to take into account replacement and refurbishment needs of all known assets, whether currently in service or not). At this point, after two years of experience, actual replacement needs are running slightly below those forecast by the RPM. Staff is reviewing results to see if the estimated useful lives of certain asset classes should be increased from the original engineers’ estimates. If so, staff may recommend that a portion of the Replacement Fund balance be released into undifferentiated reserves, or that the annual appropriation to the Replacement Fund be reduced. Staff believes that future update intervals of three to five years will be sufficient to monitor Replacement Fund performance, especially since the purpose is to support long-term, not nearterm, financial policy. - 11 -

SUMMARY The replacement planning approach used by the Orange County Water District has helped establish long-term financial policies that will enable it to maintain the integrity and quality of its infrastructure into the indefinite future. The establishment of its Replacement Fund, and the level of detailed analysis in the Fund’s formulation, have contributed to the District’s enjoyment of one of the highest bond ratings of any water agency in California. The approach chosen has also contributed to OCWD’s planned compliance with the requirements of GASB 34 and, it believes, represents a major component of a sound asset management program.

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